Lesson 3.1

Question 1

managers face decisions characterized by 2 conditions:

Answer 1

1) strategic nature

2) incomplete info

Question 2

define risk

Answer 2

hazard or chance of loss

Question 3

define probability

Answer 3

the likelihood or chance that something will happen

Question 4

what is P(outcome A) with frequency definition of probability

Answer 4

r / R where R is number of times situation is repeated and if outcome A occurs r times

Question 5

define frequency definition of probability

Answer 5

an event’s limit of frequency in a large number of trials

Question 6

define subjective definition of probability

Answer 6

the degree of a manager’s confidence or belief that the event will occur

Question 7

define probability distribution

Answer 7

a table that lists all possible outcomes and assigns the probability of occurrence to each outcome

Question 8

2 rules in probability distribution

Answer 8

1) probabilities must sum to 1 if outcomes are mutually exclusive
2) probabilities cannot be less than 0 or greater than 1

Question 9

formula for expected value of profit

Answer 9

sum of profit * probability for each outcome

Question 10

define decision tree

Answer 10

a diagram that helps managers visualize their strategic future

Question 11

what does decision tree represent?

Answer 11

represented situation as series of choices, each of which is depicted by a fork

Question 12

explain decision fork

Answer 12

represents choice by which managers must commit to a strategy; represented by squares

Question 13

explain chance fork

Answer 13

represents point at which chance influences the outcome

Question 14

what do we do when a branch is nonoptimal?

Answer 14

we place 2 vertical lines through it

Question 15

value of perfect info

Answer 15

the increase in expected profit if manager can obtain completely accurate info concerning future outcomes

Question 16

why do managers purchase info?

Answer 16

to reduce uncertainty from imperfect or incomplete info

Question 17

what is expected value of perfect info also?

Answer 17

reservation price for obtaining info (expected profit with perfect info - expected profit without perfect info)

Question 18

define utility function

Answer 18

function used to identify the optimal strategy for managers conditional on their attitude toward risk / level of satisfaction attached to each possible outcome

Question 19

what is the rational manager?

Answer 19

one who maximizes expected utility

Question 20

what is utility?

Answer 20

value that is attached to all possible outcomes of the decision by manager

Question 21

relationship between utility and monetary gain

Answer 21

Utility generally increases with monetary gain

Question 22

x axis and y axis of utility function

Answer 22

profit/wealth on x axis and utility on y axis

Question 23

define risk averters

Answer 23

when managers prefer a choice with a more certain outcome to one with a less certain outcome, when confronted with gambles offering equal expected wealth

Question 24

graph of utility function of risk averters

Answer 24

Graph increases with decreasing slope; diminishing marginal utility

Question 25

relationship between utility and monetary gain for risk averters

Answer 25

Increase in monetary gain of $1 is associated with smaller and smaller increases in utility as wealth/profit grows

Question 26

define risk lovers

Answer 26

when managers prefer a gamble with less certain outcome to one with a more certain outcome when confronted with gamblers offering equal expected wealth

Question 27

relationship between utility and monetary gain for risk lovers

Answer 27

Increase in monetary gain of $1 is associated with larger and larger increases in utility as wealth/profit grows

Question 28

graph of utility function of risk lovers

Answer 28

Graph increases with increasing slope; increasing marginal utility

Question 29

define risk neutral

Answer 29

when a manager maximizes wealth, regardless of risk

Question 30

relationship between utility and monetary gain for risk neutral

Answer 30

Increase of $1 in monetary gain is associated with constant increase in utility as wealth/profit grows

Question 31

graph of utility function of risk neutral

Answer 31

Increasing graph with constant slope; constant marginal utility

Question 32

utility function for risk neutral

Answer 32

utility is linear function of profit/wealth (U = a + b(profit)) where b is positive

Question 33

expected utility for risk neutral

Answer 33

E(U) = a + bE(profit)

Question 34

when is expected utility maximized for risk neutral

Answer 34

Expected utility can only be maximum when expected profit/wealth is maximum

Question 35

define standard deviation

Answer 35

a measure of variation or dispersion of a payoff about its expected value

Question 36

formula for SD

Answer 36

(sum of probability of occurrence * (profit - expected profit)^2)^0.5

Question 37

what does larger SD imply and why

Answer 37

Larger standard deviation implies greater risk; there is a greater likelihood probability would depart greatly from expected value

Question 38

what do managers assume when using SD as measure of risk

Answer 38

When using standard deviation as measure of risk, managers assume scale of project is held constant

Question 39

do larger investments have larger standard profit deviations?

Answer 39

yes

Question 40

how do we take into account scale of project when measuring risk?

Answer 40

To take into account of scale of project, measure of relative risk is required, this is the coefficient of variation

Question 41

formula for coefficient of variation

Answer 41

V = standard deviation / E(profit)

Question 42

define certainty equivalent approach

Answer 42

when a manager is indifferent about certainty and a gamble, the certainty equivalent (Rather than expected profit) can identify if the manager is a risk averter, risk lover, or risk neutral

Question 43

if certainty equivalent < expected net worth

Answer 43

risk averter

Question 44

if certainty equivalent > expected net worth

Answer 44

risk lover

Question 45

if certainty equivalent = expected net worth

Answer 45

risk neutral

Question 46

how can we estimate certainty equivalent?

Answer 46

indifference curves

Question 47

why do indifference curves for certainty equivalents slope upwards to the right as opposed to the ones in chp 3?

Answer 47

because the manager prefers less risk to more risk

Question 48

graph of indifference curves for certainty equivalent axes

Answer 48

Indifference curve graph has x-axis expected net worth and y-axis is risk (coefficient of variation), x axis where y = 0 is certainty equivalent

Question 49

what will indifference curve be if risk neutral?

Answer 49

horizontal

Question 50

what do indifference curves show?

Answer 50

certainty equivalent corresponding to various uncertain outcomes

Question 51

how to find risk premium from indifference curves?

Answer 51

from riskiness of investment, do ERR at riskiness - ERR at y intercept

Question 52

range of values SD can take

Answer 52

0